Donato Masciandaro – More Courage Against Toxic Finance

The European Union took a step in the direction of regulating financial derivatives. This is good news, as long as it represents only the first step on a path whose objective is to neutralize, once and for all, the potential toxins that the distorted use of derivative tools has thus far procured. Otherwise, we risk having effects that are null or, worse, counterproductive, regarding the prevention and control of systemic instability. The European norm formally initiates a centralization process of the exchanges of some types of derivatives that, however, will not be concretely in effect, it is believed, before summer 2014. Hence, it is a timid, partial and late start.

In order to define the optimal regulation of a derivative tool one must answer a simple question: what is its toxicity rate? The toxicity of any financial contract—therefore including derivative contracts—depends on its potential contribution to systemic risk. The systemic risk is what a great number of economic actors pay, irrespective of the degree to which they contributed to the creation of that very risk.

In order to understand how a single derivative tools can contribute to systemic risk, let us take an extreme example: the Monte dei Paschi di Siena (MPS) scandal. The design and execution of some derivative tools are believed to have been the catalyst for the unstable economic and financial conditions of what was and is a traditional commercial bank. The perception of the bank’s instability probably generated damages, either effective or potential, for all those who have interests in the healthy and prudent management of the bank itself: clients, suppliers, employees, the state. In different geographic or economic outlook conditions, the instability of the single bank could have had multiple negative effects on the credibility of the entire banking system.

Beyond the specific MPS case—regarding which the analyses and evaluations are far from definitive—derivatives are particularly prone to becoming catalysts for systemic risk. And this is for a very simple reason: their production and distribution are currently contrary to the fundamental law of a healthy market economy, because it does not move in a regulated market.

The systemic risk that financial tools can cause depends on the degree to which these tools are subjected to the discipline of regulated markets. By centralizing and standardizing negotiations, regulated markets produce and disperse information in a way that financial prices and quantities exchanged better reflect the risk associated with each tool. The more a tool is the product of a regulated market, the lower the chance is that the tool will be a vector of systemic risk. Furthermore, the correct use of the financial tool could be subsidized through opportune taxation, which would penalize its use as systemic toxicity increases.

Therefore, the final objective of the regulation must be that of creating markets for all the standardized derivative tools. Alongside this, one must disincentivize the production of nonstandardized derivative tools, utilizing taxation if necessary. The disincentive must be particularly strong in the cases where the derivative contract is not defined to cover risk—so an underlying contract, either real or financial in nature, must exist—but to undertake one, thereby with exclusively speculative finalities. Additionally, the creation of regulated markets will have to produce efficient volumes and prices, which will therefore be different from the ones we see today. Furthermore, the production of derivatives will also have to create a reduction of margins, also because centralization and standardization create costs. However, if well designed, regulation costs are a necessary condition for, not a restriction to, efficiency.

Compared to the market paradigm described above, today’s derivatives represent the Far West. The lack of centralized markets exponentially increases the risks for opacity and price volatility, as well as the unjustifiable volume increase. Additionally, the fringe benefits and information asymmetries are prospering, alongside the risks of adverse selection and disloyal dealings. Hence, all the pathologies of which economic—and judicial—news are full.

The derivative tool, created as a contract to cover risk, and often degenerated into a contract of risk-taking. But it is only a degeneration because it takes place outside of the frame of transparency and creditworthiness that only regulated markets can guarantee.

Consequently, the potential damages from systemic risk increase and are then to be paid by everyone. A taxation calibrated on systemic risk is still virtually absent. The current versions, even European ones, of the so-called Tobin Tax are pasty provisions, even counterprudent ones (because they hit less toxic financial contracts harder). The effects of the Far West are evident to everyone, since at least 2008. But the status has remained unaltered.

But who would like the Far West, even if it is contrary to market principles? To those who are making profits in the Far West. A system of exchanges, global but opaque, naturally oligopolistic, creates private profits with potential public costs. Until now, the indolence of legislators—on both this and that side of the Atlantic—could have been explained as incapacity or collusion. Now a step has been taken, in Europe as in the United States. Something is moving. Could this time be a good one?